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Sovereign wealth funds are increasingly screening their
portfolios based on so-called social criteria. Does that hurt
returns? Does it change corporate behavior? And does that
matter?

As sovereign wealth fund assets surge, more
investments are being screened for so-called environmental,
social and governance (ESG) criteria. Norges Bank Investment
Management (NBIM), which oversees Norway’s $861
billion
Government Pension Fund Global announced just last month
that in 2014 it had divested stakes in 49 companies, which it
did not name, based upon ESG considerations, bringing the
number of companies it has dumped in the past three years to
114.

NBIM culls companies from the fund based on a
variety of
criteria, ranging from human rights violations to
environmental damage. Other sovereign wealth funds have their
own restrictions. The $548 billion
Kuwait Investment Authority (KIA) declares: "KIA does not
invest in sectors where gaming or alcohol-related activities
constitute the main source of business." The $21.5 billion
New Zealand Superannuation Fund, among other things like
nuclear arms makers, excludes companies that process whale
meat. And Australia’s $95.4 billion
Future Fund is not alone in nixing makers of cluster
munitions and anti-personnel mines.

Even the often mysterious
Qatar Investment Authority, with an estimated $304.4
billion in assets under management, says on its website that it
factors in "environmental considerations into our investment
decisions."

Given the diversity of the funds in question,
there is some lack of consistency. For example, two of the
Future Fund’s top holdings last year — Rio Tinto and Honeywell
International — appear on the roster of companies
in which Norway’s fund is forbidden from
investing. And the Australian fund’s big
alcohol-related holdings include Diageo,
LVMH Hennessy Louis Vuitton
and Heineken.

Stunning Outperformance

Sovereign wealth fund are just part of a pack of
institutional investors applying ESG criteria to their
portfolios. The United Nations-supported Principles for Responsible
Investment lists 1,368 signatories with assets over $45
trillion. The group has a range of investment guidelines to
which it expects members to adhere.

Most — but not all — social
screening seems to zero in on the perfidy of tobacco stocks.
Indeed, NZ Super devotes an entire section of its website
explaining its rationale for shunning the perfectly legal
industry, including the assertion that doing so would not
materially damage fund returns. NBIM, the Future Fund and
scores of pensions, endowments and mutual funds likewise avoid
tobacco makers.

Now, new research shows that shunning cigarette
makers and their ilk may hurt performance badly over the
long-term. The data backing this up was published last month in
the Credit Suisse Global Investment Returns Yearbook 2015 in a
study by Elroy Dimson, Paul Marsh and Mike Staunton of London
Business School.

The study looked at U.K. and U.S. tobacco stocks
going as far back to 1900 — an exceptionally long time
frame, though the U.K. tobacco stocks were traced back only as
far back as 1919. U.S. tobacco stocks returned 14.6 percent
annualized from 1900 through 2014, versus just 9.6 percent for
the U.S. stocks overall. U.K. tobacco stocks showed a similar
outperformance over a somewhat shorter time frame, returning
13.1 percent annualized from 1919 through 2014 as against 10.3
percent for the U.K. market overall.

Put another way, $1 put into a U.S. tobacco stocks
in 1900 would have grown to $6,280,327 by the end of last year.
That’s not a typo. The same $1 put into the U.S.
stock market overall would have grown to just $38,255 by year
end 2014. Any way you look at it, there has historically been a
stunning outperformance by a sector that is now on many
state-owned investors prohibited lists.

Screening Issues

The study feeds into a contentious issue for
sovereign wealth funds — whether instituting screening
helps or hinders returns. Over the years, studies have shown
that socially screened investments out- or under-perform.
It’s often a function of whether growth or value
stocks are in fashion during the time frames studied, as well
as the fortunes of industries like technology, industrials or
hydrocarbons, which themselves fall into the growth and value
categories.

Social screens helped in the technology bubble for
example. "It will help in some markets like the late 1990s and
hurt in the mid 2000s, when energy was doing well," says David
Kathman, a senior analyst who tracks socially-screened
investing at at Morningstar, the Chicago–based
financial publisher. "It tends to balance out over time given a
long enough time frame."

More data may be necessary. "The jury really is
out," says professor Larry Catá Backer of Pennsylvania
State University, referring to the question of how such
screening effects performance. "I think on balance it
doesn’t really hurt. It’s a big
investment universe."

In the case of tobacco stocks, a 2000 study by
Northfield Information Services in Boston examined the
financial impact of the California State Teachers Retirement
System’s decision to divest from all tobacco
stocks that year. It found that the differences in risk and
performance between the S&P 500 Index and a tobacco-free
version of the benchmark were neither statistically nor
economically significant. That’s not surprising
given that at year end 1999 tobacco stocks accounted for less
than 1 percent of the market capitalization of the index.

"What you can ask is if you take the stocks out of
the portfolio, is that material?" asks Dan diBartolomeo,
president of Northfield, a research firm that works with
sovereign wealth funds on screening issues. "Is it small enough
that you don’t have to worry about it?"

Creative Substitution

What explains the searing outperformance of
tobacco stocks over the years? That’s hard to say,
although having an addicted client base probably helps. Lloyd
Kurtz, a lecturer at the Center for Responsible Business at the
Haas School of Business at the University of California
Berkeley, says it comes down to fundamentals. "The returns from
tobacco stocks were factor driven," he says. "They were just
cheap stocks." Fine, but also give some credit to sky-high
dividends over some of that period.

Underpinning some of the tobacco
stocks’ outperformance may be that they are simply
riskier stocks, and investors are demanding higher returns for
holding them. "If they are such outstanding bargains why
haven’t they been bought out by a sophisticated
buyer?," Kurtz asks. "If I was investing in a company that had
a one percent chance of a catastrophic event, I would demand a
much higher return. I think there’s some
irrational risk delusion in the market."

The six major U.S. cigarette makers entered into a
Tobacco Master Settlement Agreement with the attorneys general
of 46 U.S. states in 1998, agreeing to pay an estimated $206
billion and to stop a variety of marketing practices. It proved
a smart move for big tobacco, locking them in as the market
leaders. But in the U.S. legal system strange things can and do
happen. Hence the risk.

Enough about smokes — profitable as
investing in them may be. What about other forbidden
industries? "Decarbonization" is now a buzzword among
institutional investors and the prospect of selling off
hydrocarbon-spewing holdings like oil and coal companies is
squarely on the agenda, if not for sovereign wealth funds, at
least plenty of endowments and other institutions.

Then it becomes a question of a fund maintaining
appropriate diversification if it decides to divest from energy
stocks. "You’re going to have a different
composition if you decarbonize than if you boycott tobacco,"
says Kurtz.

Ethical Argument

A possible solution is a sort of synthetic
replication of oil producers’ characteristics
— creative substitution. For example, DiBartolomeo
says big box retailers do particularly well when oil prices
fall. That’s not only because consumers are less
worried about gas money when they drive to the local mall with
more money in their pockets. Large retailers also spend an
enormous amount of money on heating and air-conditioning.
Falling fuel prices reduce costs and expand margins.

"So you short the big box retailers," says
diBartolo, explaining that the net effect is equivalent to a
bet on energy producers. "There are ways to compensate." He
calls it portfolio optimization.

There are certainly limits to this tactic. Kurtz
points out that a sovereign wealth fund aiming to purge its
portfolio of atomic power producers is going to have a bigger
problem. "If you exclude nuclear you’re excluding
almost every utility." That’s hard to replicate in
a synthetic fashion no matter how creative a portfolio manager
is.

Ultimately, it may come down to this: If an ESG
prerogative is to steer clear of a particular company or
industry, it may just be that stakeholders will have to live
with lower returns, less diversification and higher risk. That
may not be such a bad trade off, depending on
one’s world view.

"We think in terms of of risk and rewards," says Kurtz.
"Social investing is something else...There’s a
risk in terms of turning the ethical argument into a financial
one." In other words, investors may just have to decide that
surrendering some return is the price of a clean conscience. In
the case of sovereign wealth funds it bears noting that as
state-owned investors, they do, to one degree or another,
represent a projection of their parent nations’
values as they invest around the world.

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